Taxable Asset Allocation of Municipal Bonds

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Taxable Asset Allocation of Municipal Bonds

Postby jbaron » Thu May 05, 2011 1:31 pm

I like to think that I understand the concept of adjusting asset allocation for tax status, and I practice such. However, I find that my bond allocation is soon to be larger than my tax advantaged spaces, and so I am into bonds in taxable spaces, which for me means municipal bonds.

When I devalue positions in my taxable accounts (equities), I devalue them by 1-taxrate, which I generally assume to be about 75% net. This accounts for a lower tax on capital gains, the fact that I live in CA, and some higher tax rate on the small-ish amount of dividends.

I am at a loss, however, when it comes to municipal bonds. Devaluing those bonds by 25% doesn’t seem correct, as there’s little effect from capital gains rates, and devaluing them by 45% doesn’t seem right either. What does seem right is to devalue them by some nominal amount – say, 5% to account for various contingencies, or perhaps more appropriately, to devalue them not at all.

I’m tempted to devalue them not at all, but this does lead to some complexities when it comes to asset allocation: reallocating from equities to municipal bonds in a taxable account “moves the target” a bit as the dollar amounts shift from a 25% devaluation to a 0% devaluation.

But still, this seems like the right thing to do. Having a 4% 10-year municipal bond would seem to involve the same risk and returns as having a 4% treasury note in a Roth IRA account, a position that I’d not devalue at all. (Well, same except for the issuer risk, of course.) Zero devaluation also leads to the conclusion that in a 25% tax bracket, a 4% treasury note in a taxable account has the same “asset allocation value” as a 3% municipal bond in a taxable account, excluding gains or losses from the changes in the value of the bond, which would be valued equally.

Any thoughts?

Thanks,

Jeff
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Postby phositadc » Thu May 05, 2011 2:36 pm

I don't think I truly understand your question, but I would just remind you that municipal bond interest will be taxed at the state level unless you own a state-specific muni bond fund and you live in that state.

So in CA, your muni bond interest could be taxed up towards 10% if you have a high income.
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Postby denismurf » Thu May 05, 2011 2:44 pm

For better or worse, I do what you do, with no adjustment for the munis. However, I might do this differently if I held bond funds, not individual bonds. I don't plan on having to figure that out.
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Postby jbaron » Thu May 05, 2011 3:15 pm

denismurf,
Do you mean that with munis, you simply use the same 75% factor that you use with equities? And when you say, "for better or worse," is that because you think that what you do is incorrect, or that you don't know what "correct" is?
Thanks,
Jeff
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Postby natureexplorer » Thu May 05, 2011 3:52 pm

Huh, why would you devalue munis unless they have significant unrealized capital gains?
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Re: Taxable Asset Allocation of Municipal Bonds

Postby bearwolf » Thu May 05, 2011 3:57 pm

jbaron wrote:When I devalue positions in my taxable accounts (equities), I devalue them by 1-taxrate, which I generally assume to be about 75% net. This accounts for a lower tax on capital gains, the fact that I live in CA, and some higher tax rate on the small-ish amount of dividends.

Any thoughts?

Thanks,

Jeff

Do you devalue the entire value of your equities or just the gains? If you have a fund value of $100,000 and you sell it the only part that is taxed is the gain not the full 100K.

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Postby jbaron » Thu May 05, 2011 5:45 pm

natureexplorer wrote:Huh, why would you devalue munis unless they have significant unrealized capital gains?

By "devalue", I do not mean "assume that I'll have to pay taxes on this money." Rather, I mean that my return and my risk after taxes are different than my return and my risk before taxes.

I think that asset allocation should be based on after tax characteristics, not before tax characteristics. So, even though you may have $100,000 in a taxable account invested in treasury notes that are currently priced at par, the IRS will share in any gain or loss that you incur or any income that you receive. That means that your return is not, say, 5%, but rather 4%. That is a different set of risk and return numbers that would be characteristic of the same investments in a Roth IRA, for example, even though the principal of the bonds are after-tax is both instances.

My question - then - is given that treasury notes in taxable accounts should be "devalued" for asset allocation purposes, should municipal bonds also be devalued in the same fashion?

Jeff
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Re: Taxable Asset Allocation of Municipal Bonds

Postby jbaron » Thu May 05, 2011 6:28 pm

bearwolf wrote:Do you devalue the entire value of your equities or just the gains? If you have a fund value of $100,000 and you sell it the only part that is taxed is the gain not the full 100K.

BearWolf

I devalue all of the value, not just the part above the basis, and here's why: My share of the increase in after-tax value of the position is not dependent on my basis.

When my equity position has a value V and a basis B, my after tax gain is the after-tax value after the period, which is V’-(V’-B)*taxrate, minus the after tax value before the period, which is V-(V-B)*taxrate. (When the position is a new one, the basis is equal to the value and B=V, so the after tax value before the period is simply V.)

So, my after tax gain is [V’-(V’-B)*taxrate] minus [V-(V-B)*taxrate], or (V’-V) + (-V’+B+V-B)*taxrate = (V’-V)*(1-taxrate). In other words, my after tax gain is dependent on the value of the position, but not on the basis. This makes all of the usual assumptions about tax rates, and also assumes that dividends are non-existent. With dividends, the math is more complicated and the numbers are not quite the same, but I ignore that factor.

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Postby biasion » Thu May 05, 2011 6:32 pm

Municipal bonds are actually one of the most valuable investments in your portfolio because they, more than any other asset class, allow the small investor to outperform the market assuming you are willing to take on a liquidity premium.

I am fairly heavily invested in municipal bonds, and they take up somewhat more than 15% of my asset allocation (I am 72/28 right now). Since I hold some bonds in my kids' 529, I would say it is the largest fixed income invesmtent I currently own.

I favor individual municipal bonds because you don't pay the expense ratio fee, you can control the maturity, and more importantly you can control the credit quality. Even Vanguard's fund is about 30% in single A or lower (including more than a few BBB bonds) whose performance you can't really trust because investing this low opens you up to risks, and just because something is unlikely doesn't mean it's impossible.

The best part about individual municipals is that the yields are actually higher due to the volume premium. While smaller lots, lots of face value of 5 or 10 have a higher markup, the demand for them is generally so low that if you find a discount broker that presents lowball bids, more often than not you get a very nice boost to your returns.

Understandably, if you find a municipal bond that has a higher yield than other bonds of its credit quality and maturity, more often than not it is a sign that there is trouble brewing and the market is spelling problems. On the other hand, yields of 50-100 basis points higher, particularly at the shorter end of the curve, are not unheard of.

Example: I recently bought a bond due in Jan 2013 for a 1.35% tax free yield; it was pre-refunded in US treasuries. The only difference is that it was a lot of 5 bonds, far less liquid that US treasuries. In this market, 1.35% after tax return for under 2 years is pretty good. A week or two before, I purchased another pre-refunded, again escrowed in US Treasuries, that was due in 1-2021 with a 4.05% yield, tax free when US treasuries due in 2011 were paying merely 3.4% or so.

In this case, as long as you keep to maturity, you basically pocket the yield difference as a risk premium that is never realized.

So to me, municipals actually outperform and are more attractive than any other fixed income due to the bump in yield.

Again, warning to the higher yielding bonds that seem to be well rated! If it's too good to be true it is.

I suggest before you start this way, read Larry Swedroe's bond book, Annette Thau's bond book, maybe 1 or 2 other books on municipals, as well as Larry Swedroe's alternative investment book which covers fixed income pretty well.

I use Stoever Glass www.stoeverglass.com I am very happy with them. Ask for Russell Stoever and say you are a new client. Tell him the doctor who posts online recommended you, and you are looking for bonds of similar quality and lot size as he (stable AA/AAA). Favor pre-refundeds as well.

Lastly, I also recommend paying to join the website www.municipalbonds.com and look up bonds here before buying by the CUSIP number.

It will tell you what the moody's rating is, when it was most recently given, what the most recent credit report was, and any negative credit watch or downgrade expectations are.

Watch for bonds that are at least AA-/AA3 and also not on a negative watchlist. Sometimes a bond will be insured. There are one or two monoline insurers still investment grade. One is even rated AA1, but on negative watch list. Always buy bonds based on their underlying credit rating, but sometimes if the rating holds for the insurer, it will say AA1/negative because that one insurer is the higher of the two. However, ask Russell Stoever or dig deeper yourself what the underlying credit rating is. It may still be worth buying because even if it's AA2 or AA3 and stable, that one more highly rated (but on a negative watchlist) insurer will show up.

So welcome to the world of municipals. You will find it one of the most gratifying investments you ever made as long as you're careful to stay at the creme de la creme, so much so that you will delay funding your 401k so you can buy munis. Of note, that's exactly what I did in Jan/Feb and stopped my contributions so I could buy more municipals into that falling market.

Hope that helps.
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Postby yobria » Thu May 05, 2011 7:39 pm

I'd treat 'em the same as my Roth for tax adjustment purposes.

Unless you want to deduct a bit for the (slight) risk of default.

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Re: Taxable Asset Allocation of Municipal Bonds

Postby grabiner » Thu May 05, 2011 9:19 pm

jbaron wrote:I like to think that I understand the concept of adjusting asset allocation for tax status, and I practice such. However, I find that my bond allocation is soon to be larger than my tax advantaged spaces, and so I am into bonds in taxable spaces, which for me means municipal bonds.

When I devalue positions in my taxable accounts (equities), I devalue them by 1-taxrate, which I generally assume to be about 75% net. This accounts for a lower tax on capital gains, the fact that I live in CA, and some higher tax rate on the small-ish amount of dividends.

I am at a loss, however, when it comes to municipal bonds.

But still, this seems like the right thing to do. Having a 4% 10-year municipal bond would seem to involve the same risk and returns as having a 4% treasury note in a Roth IRA account, a position that I’d not devalue at all. (Well, same except for the issuer risk, of course.)


And the risk is the relevant point. A reasonable assumption is that a municipal bond pays 25% less than a corporate bond of comparable risk; therefore, your 4% municipal bond is equivalent to a 5.33% corporate bond, on which you lose 1.33% a year to taxes. Compound that loss over your time horizon to see how much you are losing by holding a municipal bond in taxable instead of a corporate bond in a Roth IRA.
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Postby jbaron » Fri May 06, 2011 12:47 am

Thanks David. Let me mull this over.

Jeff
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